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Tuesday, 7 October 2014

Portfolios:Azzad Asset Management Likes Non-Conventional Sukuk

Sukuk, Islamic equivalent bonds, are in and of themselves beyond the boundaries of many portfolio managers of advanced economies even in the most flexible mandates, but in the Islamic finance world, it's the non-Islamic sukuk issuers that are non-conventional, and this is where Azzad Asset Management sees value.

"Currently we see value in some of the non-conventional issuers," said Ihab Salib, the lead portfolio manager for the firm's sukuk fund, the Azzad Wise Capital Fund (WISEX).

"As maiden issuers in the market, they need to price the sukuk generously so as to tempt investors," he commented.

South Africa's September issuance was a case in point.

The 2020 South African government sukuk offers a 20 basis point pick up in return relative to the conventional debt of the same maturity, he argued.

South Africa was the latest non-Muslim country to grace the ranks of sukuk issuers with a $500 million June 2020 sukuk issuance in September.

Particularly noticeable was the UK government debut in June with a GBP200 million July 2019 sukuk issuance, which, like South Africa, was largely oversubscribed, with orders totaling about GBP2.3 billion, according to the UK Treasury. The profit rate of 2.036% was "in line with the yield on gilts of similar maturity," the UK government said.

Just as importantly, "allocations have been made to a wide range of investors including sovereign wealth funds, central banks and domestic and international financial institutions," it added.

Illustrating the growing worldwide interest in tapping the pools of Muslim wealth, investors were not only from the Middle East, but also from other centers for Islamic finance, notably Asia and Britain.

Likewise, the investor base for the South African issuance went beyond the Middle East and Asia, which still took the lion's share with 59%. The transaction was indeed allocated to European investors (25%), U.S. investors (8%), the remaining balance being distributed to "the rest of the world."

In September, Hong Kong also issued its inaugural sukuk, with 11% distributed to fund managers, 56% to banks and private banks, 30% to sovereign wealth funds, central banks and supranationals, and 3% to insurance companies.

On the corporate side, Goldman Sachs also tapped the sukuk market in September.

Going forward, "although 2014 has been a slow year for sukuk issuance, we are quite positive on future issuance from both sovereign and corporate issuers," Azzad Asset Management's Salib said.

"Over the next year we expect to see more non-conventional issuers tap the sukuk market for funds, as the market offers issuers a large and stable capital pool," he continued, a development he would welcome as an investor.

Sukuk are financial certificates representing ownership in real assets as well as the right to the cash flows they generate and to the proceeds from the sale of the assets. As such, they comply with Islam's prohibition on charging or paying interest. Traditional bondholders, on the other hand, own debt.

In addition to non-conventional issuers, Salib sees "some value in the Dubai complex" despite the spread tightening since the beginning of the year, especially the hospitality and retail sectors.

More generally, from a fundamental standpoint, the Gulf Cooperation Council, which includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates, "offers the market the greatest support," Salib commented.

"Being a low population, hydrocarbon rich region whose governments run fiscal and current account surpluses, the economic backdrop is extremely conducive," Salib said, who also pointed out the solid balance sheets of individual issuers, many of them government owned.

Yet, sukuk are not entirely insulated from interest rate risk.

And as the Federal Reserve is preparing to hike rates, most likely next year, with potential implications worldwide, Azzad Asset Management is trying to limit its interest rate risk "by staying in fairly short-dated securities."

"Of course the sukuk market does not live in isolation to the rest of the fixed income markets, and the next cycle of increasing rates will prove a challenging headwind to demand," Salib said. "However the unique nature of the market along with its stability should see positive demand mechanics continue."

Yet, the market is quite illiquid relative to the traditional bond market despite a growing demand and supply and a broadening of the investor base in the sukuk market.

"Typically sukuk are bought and held right through to maturity by the investor base, and although a good thing in terms of price action, this can make it quite challenging when attempting to trade securities," he said.

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